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Analysis of Free Trade Agreement by Cooperative Game Theory

1. Introduction

in February 2004 and made effective in January 2005. For the first time the AUSFTA has presented a solution to a very interesting problem of how to treat agricultural products in an FTA between two advanced countries that are major exporters of agricultural products. The solution suggests the conclusion that trade liberalization without exception is inconvenient even for a country that actively promotes trade liberalization. As is well known, both the US and Australia call for aggressive liberalization of trade in agricultural products in WTO negotiations.

Nonetheless, between themselves, they faced difficulty on agricultural trade and finally reached a compromise to exclude certain products from liberalization.

This paper will analyze the negotiation process of the FTA concluded between the US and Australia, and its economic impact by the bargaining theory. The paper is composed as follows:

first, conditions of a successful negotiation for general tariff rate reduction between two countries are analyzed, employing bargaining theory. More specifically speaking, the necessity of negotiation and conditions for successful compromise is discussed within the framework of game theory. Secondly, this paper analyses the effect and impact of the AUSFTA on economic welfare and trade by GTAP (Global Trade Analysis Project), a general equilibrium model for analyzing trade liberalization.

Note (1) Bhagwati[2]on the issues arising from disorderly conclusion of FTAs

2.Analysis of Trade Liberalization Negotiations, Based on Bargaining Theory (1) Analysis of Tariff Competition

Riezman [8] applied the combined analysis framework of a non-cooperative game and a cooperative game to the analysis of tariff competitions with tariff negotiation and without. First, a tariff competition is explained in a framework of non-cooperative competition.

Assuming a profit matrix of the tariff competition game as given in Table 1 above, the Nash equilibrium is the “maintenance of the tariff” for both countries. Firstly, if the first country opts for “tariff elimination”, the second country can obtain a higher profit by “maintaining the tariff”.

However, when the second country opts for the “maintenance of the tariff”, the first country can obtain a higher profit by “maintaining the tariff”. When the first country changes its strategy to the “maintenance of the tariff”, the second country can obtain a higher profit by “maintaining the tariff” than by taking any other strategy, so that the second country does not change its strategy. When both countries take the strategy of “maintaining the tariff,” there will be no incentive for each party to change its strategy. This is the Nash equilibrium formed in a tariff competition.

However, the Nash equilibrium is not the best combination of possible and desirable strategies. As a party is able to increase its own profit from the Nash equilibrium without damaging the other party’s profit, the Nash equilibrium is not Pareto optimal. In other words, both parties can increase profits above the Nash equilibrium when both parties take the strategy of “tariff elimination”. In a tariff competition, the result of each party’s reasonable policy option will not be reasonable as a whole. This is called unsatisfied common rationality. In order that both parties pursue profit higher than the Nash equilibrium, it is necessary to introduce negotiation.

(2) Analysis of Tariff Negotiation

Next examined is the case where the parties will cooperate for the purpose of increasing their own profits, or a negotiation case (1). First it is necessary that both parties are always able to win

more profit through negotiation than the non-negotiation case. Otherwise, neither party has any motive to start negotiation. This is called the assumption of individual rationality. Profit obtained without negotiation is called the reference point of negotiation d =(d1,d2)(2). Here, based on Table 1, the reference point of negotiation is deemed to be the Nash equilibrium where both countries “maintain the tariff”. Starting from this point, both countries set out to negotiate to seek further profits.

The non-cooperative game was a definitive analysis (3) composed of two strategies for each party and four conclusions. Now a statistical concept is introduced to single out one conclusion from the four. This is called the concept of mixed strategy. Each of the four conclusions is given a probability of occurrence as follows;

(

z11,z12,z21,z22

)

z = zij ≥0

∑∑

2 2 =1

i j

zij (3)

The method of determining in correlation with each other’s option is called a correlated mixed strategy. Each player must negotiate in order to increase his own expected profit.

By setting up as above, a set of realizable expected profits can be determined. This set is called a realizable negotiation set U. A vector in U of expected profits realizable through cooperation is expressed as u=(u1,u2). Besides, the expected profit realizable through negotiation shall satisfy the condition of individual rationality. Therefore,

i

i d

u > i=1,2dU (4)

When a set of realizable negotiation is charted, based on Table 1, Figure 1 is drawn. The origin O is made the reference point of negotiation d. The reference point represents the expected profit obtained by both countries when taking the strategy of “maintaining the tariff”.

Negotiation will not be agreed upon unless expected to increase profit further. Therefore, Point B, realized only when the first country selects the strategy of “maintaining the tariff” and the second country opts for the strategy of “tariff elimination”, or its opposite point C is excluded from negotiation. To be negotiated is the region above the point of reference O in the set of realizable negotiation. The shaded area OEFD in Figure 1 represents that region. Point F represents the expected profit obtained when both countries opt for “tariff elimination” at 100%

probability.

In the region of negotiation any random point on EFD is Pareto optimal. For example, the point of negotiation conclusion is assumed to be point G in the shadowed region. Point G represents increased profit for both countries, being in the shadowed region. But negotiation continues for further profit increase, because negotiation makes it possible for both countries to increase expected profit of the first country without decreasing expected profit of the second country realized at point G. Conversely it is possible to increase the profit of the second country without decreasing the first country’s. At point G Pareto optimum is not satisfied, and there remains room for negotiation to increase expected profits mutually. On EFD, however, it is not possible to increase one party’s profit without sacrificing the expected profit of the other party, so that Pareto optimum is satisfied.

Now the expected profit that is added to the profit at the point of reference is expressed as

i i

i u d

W = − and the product of both countries’ profits is written as W0 =W1W2. So far as negotiation aims to maximize W0, the point of negotiation conclusion is the point of contact of EFD satisfying Pareto optimum and W0 in the region of negotiation. Figure 1 shows a case where the point of contact comes on Point F. At this time tariff elimination is opted for in both countries as a solution of negotiation.

(3) Free Trade Being No Solution of Negotiation

In the course of FTA negotiation, an agreement, short of perfect free trade, is often reached

incidentally through compromise, by excluding exceptional commodities or establishing a long transition period until tariff elimination. Such a compromise could be theoretically affirmed, because it is required that some conditions are satisfied in order to conclude a negotiation for perfect tariff elimination.

Two examples demonstrating that a negotiated solution is not free trade with perfect tariff elimination are shown (Figure 2). Figure 2 (a) illustrates a situation where the second country can only earn profit below the point of reference in free trade. As Point F is located in the 3rd quadrant, free trade is out of the region where free trade is negotiable. In other words, free trade does not satisfy the condition of individual rationality, so that it is not negotiated. This kind of case is called “Johnson’s case”.

In Figure 2 (b) it is indicated that free trade may not become a solution of negotiation, even if it satisfies the condition of individual rationality and is found in the quadrant where it is negotiable. Point F is located in the first quadrant, satisfying the condition of individual rationality for both countries, but Curve W0 does not contact Point F, so that Point F is not chosen as a solution of negotiation.

Note (1) In this paper the word “cooperation” means all activities from discussion and negotiation to agreement and sure performance with enforceability.

(2) The point of reference for negotiation also means profit obtainable after negotiation has failed, so that it is also called the breakdown point of negotiation.

(3) The definitive analysis as described above is called a pure strategy.

3.Economic Impact of the US-Australia Free Trade Agreement

In this section, we look over the process and the result of AUFTA negotiation as a case study.

We analyze potential economic impact caused by AUFTA and implication of the agreement based on the bargaining theory. We also try to find which country would benefit from the AUFTA accomplished by compromise of both countries.

(1) The negotiation process and the contents of agreement of the AUSFTA

There were five rounds of the AUSFTA negotiation in total. Information on the negotiating process is obtained from the content of the press conference held after each round. When the 1st and 2nd negotiating (March and May, 2003), the information was exchanged to deepen mutual understanding about a basic matter concerning the agriculture of the two countries that seemed to be necessary for the conference. In the negotiation on the 3rd (July of the same year), the offers concerning the market access of the two countries were exchanged for the first time. The access of agricultural products to the US market became one of the important issues in the 4th negotiation (October of the same year). Even in the negotiation on the 5th (December of the same year), two countries could not have agreed although there was some progress in the agricultural sector which was one of the most difficult in the negotiation.

It was sugar that tangled and prolonged the negotiation in the agricultural sector. This is because the US sugar lobby asserted their strong political influence to the negotiation. The negotiation was forced to be extended to the next year. At the press conference in January 2004, trade ministry of Australia declared that it was sugar that made negotiations so difficult and it was the result of the sugar lobby which could strongly influence to the negotiation while most of negotiation process keeps secret because of negotiation still under going.

Next, let's outline the agreement of the US-Australian FTA. The US and Australia agreed to abolish most of their tariffs. Australia is going to abolished tariffs of 10,405 products. The US

are going to abolish the tariffs of 6,117 products. The abolition of the tariff will be gradually executed. Australia is going to abolish all barriers by 2015, and The US is going to abolish 99.5% of all tariffs by 2022 which should be abolished.

It is sugar and dairy products that were admitted as the exception of the tariff abolition in the US. As for sugar, a present tariff rate quota system will be maintained. The import quota of dairy products will newly be set or increases. Tariff rate for out of quota will be maintained, while a tariff rate in quota is set to zero.

Besides sugar and dairy, the tariff rate quota is applied to beef, cigarettes, cotton, peanuts, and avocadoes in the transition period. However, quotas of these products are going to gradually increase and the rate of tariffs is going to gradually decrease during the transition period, and after the transition period tariff rate quota of them will be completely removed. Gradual abolition of tariff rate quota will be executed during four years, ten years and eighteen years respectively. In addition, it was agreed to install the safeguard against the jump in imports of beef and parts of horticulture products to the US market.

(2) What is GTAP?

GTAP is a tool for analyzing the impact of a change in tariff or export subsidy on production or trade from a global viewpoint within the framework of general equilibrium analysis. To name literature that details GTAP, Hertel’s [6] will be a typical text for further details. In a general equilibrium model, economic agents such as households maximize utility under budgetary constraint or those such as enterprises maximize profit under the constraint of the production function in a perfectly competitive economy. GTAP makes it possible to compute and analyze what change is caused in the model-calculated equilibrium prices and quantities at the time of a policy change, for instance, tariff reduction, based on the actual data.

GTAP used here is version 5. Version 5 has a somewhat old datum point in 1997. In this paper the equilibrium in 1997 and the equilibrium to be newly formed by the tariff deduction, which is presumed on a case-by-case basis, are comparatively analyzed. As already seen, some tariff rates will be reduced by stages. Also, it would take some time to make adjustment such as the shift between production factors until a new equilibrium forms after a shock. However, any such thing is disregarded and any change is deemed adjusted momentarily. This assumption that neglects any adjustment implies that the analysis aims at the middle-term effect of a change in tariff rate on the economy. Also, such impact or effect as an increase in investment, acceleration of competition or progress in technology is entirely disregarded, and only the simple static effect of tariff rate reduction is measured.

(3) Data and Scenario

When segmentation is made to the limit, employing GTAP version 5, 57 categories of goods in 66 countries/regions can be analyzed. In this paper these regions and goods are re-grouped into 20 countries/regions and 33 categories of goods, and the results are calculated. Table 6 details such calculation. As the main purpose is to analyze the impact on the agricultural sector, the category of goods is made more detailed for agricultural and fishery products and simplified in other industries, with several industries summed up.

As already mentioned, the AUSFTA is not a free trade agreement, excluding sugar, dairy, etc.

What a difference does this sort of exception make on economic impact, compared with perfect free trade? Now it is assumed as Case 1 that the US and Australia both eliminate any tariff on imports from the other country. On the other hand, if based on the draft agreement, it is necessary to recreate the tariff quota system of the US for sugar, dairy, etc. When a tariff quota system is directly expressed in GTAP, however, it is necessary to add new data concerning

model adjustment or tariff quota system. Here the tariff quota system itself is not expressed directly, but the barrier for the excepted goods is converted into tariff rate equivalent.

Specifically speaking, the tariff rate on sugar is not changed, but kept at the level of the datum point. The tariff quota is maintained for dairy products, so that the products are made subject to a 4.1% tariff rate of the US, based on CIE [4] estimation. It is scheduled that tariffs will be finally eliminated for beef, so the US tariff rate is set at zero. With respect to the other products, the tariff rate is assumed to be zero as in Case 1. These assumptions constitute Case 2 based on the draft agreement, and this is compared with Case 1.

(4) Result of Analysis 1) Equivalent Variation

In Table 2 the equivalent variation of each country is shown for both cases. For Australia it increases slightly by $44.3 million in Case 1 of perfect tariff elimination but decreases by $42.6 million in Case 2, which is based on the draft agreement excepting some agricultural products.

In order to conclude whether the AUSFTA as agreed has an adverse effect on Australia, a further examination or analysis considering dynamic effects, for instance, is necessary. However, it may be well imagined that the compromise, which has allowed the US to keep the tariff quota system on imported sugar and dairy, costs Australia at least $80 million, compared with perfect trade liberalization. Meanwhile, the US gains $378.9 million in Case 1 and $456.9 million in Case 2.

The difference between Case 1 and Case 2 only amounts to $78 million, but the equivalent variation becomes larger in Case 2 than Case 1. Thus, it can be said that the agreement as drafted is more favorable for the US.

Any third party country other than the US and Australia has a minus equivalent variation regardless of Case 1 or 2. Equivalent variations of Japan, China, and Korea are respectively minus $110.2 million, minus 37.4 million, minus 37.5 million in Case 1 and minus $98.8 million, minus 31.4 million, minus 35.2 million in Case 2. Europe’s minus $134.2 in Case 1 and minus 133.6 million in Case 2. The world total of equivalent variations for these countries and regions being the third parties amounts to minus $116.3 million in Case 1 and minus $49.7 million in Case 2. The AUSFTA itself, either in the case of perfect tariff elimination or as agreed, is not favorable from a worldwide viewpoint. But the negative impact of the compromise in the agreement as drafted is more than halved, compared with perfect free trade.

Generally it could be said that the AUSFTA has a very small static effect on the overall economy in either country. The reason is that from the very start most of the high tariff goods are agricultural products, accounting for a small share of the overall economy, and the reduction in tariff rate therefore does not have much impact on the overall economy. Although the FTA has negative impacts on the overall economy of each third party country/region, including Japan and Europe, it has turned out to be less than free trade, and it could be said that the impact is very minor.

2) Application of Bargaining Theory

In Section 2, the concept of probability has been introduced in the definitive analysis of a non-cooperative game and a solution of negotiation was analyzed. Now let us analyze the AUSFTA negotiation employing bargaining theory, assuming that equivalent variation is the profit gained by negotiation.

First the point of reference, being the starting point of negotiation, is set to be the situation before negotiation begins, and equivalent variation is set at zero in both countries. Profit obtained in case of perfect tariff elimination by both countries has the equivalent variation gained in Case 1 set as the point of free trade. Finally profit obtained when one country keeps tariffs and the other country eliminates them is regarded as the equivalent variation respectively

in case that the US (or Australia) keeps all tariff rates and Australia (or the US) sets all tariff rates at zero.

Based on the above assumptions, Figure 3 charts the AUSFTA negotiation within the framework of the analysis by Riezman [8]. The horizontal axis represents a scale to measure the US’s expected profit (equivalent variation) and the vertical axis shows Australia’s. When one country keeps tariffs and the other eliminates them, the former party’s equivalent variation=expected profit is positive but the latter party’s becomes negative to a large extent.

The point of free trade is the combination of equivalent variations of the US and Australia in Case 1. Looking individually, profit from free trade is bigger for the US and smaller for Australia. If negotiation addresses the maximization of the product of the profits obtained by both countries, the solution of negotiation is given when the profits both countries obtain are equal. In dollar terms, such obtained profit amounts to $142.0 million for each country.

Meanwhile, profits calculated for the actually agreed scheme is the “point of agreement” in the same chart, far distant from a theoretical solution of negotiation and even out of the set of realizable negotiation away from the region of negotiation.

This set of realizable negotiation is charted by giving probability to definitive profit, not by manipulating the tariff rates of the US and Australia within GTAP. Accordingly all of the combinations of profit obtained by manipulating tariff rates on all products are not included in this set of realizable negotiation. In the first place the profit obtainable from negotiation must be larger than the point of reference. Otherwise, individual rationality is not met and negotiation becomes meaningless. However, Australia’s profit calculated at the point of agreement is lower than Australia’s point of reference, and is not included in the region for negotiation.

The calculation results did not present any justifiable explanation on the ground of bargaining theory for Australia’s acceptance of the agreement as drafted. However, the following two points are still open to dispute. In the first place only the static effect of the tariff elimination of the AUSFTA is handled in the model, and the results are not based on a comprehensive analysis including the dynamic effect of the liberalization of investment. Secondly the point of reference is placed time-wise before negotiation, but there is a possibility that a failure of negotiation may result in a level of welfare below the original level or otherwise the point of reference might shift to another position. Depending upon where the point of reference for negotiation is set, it would be possible to explain the formation of individual rationality of the agreement as drafted.

For explaining why the US consistently maintained an obstinate stance and made a compromise in the field of agriculture it should also be pointed out that the economic effect of the AUSFTA is small and that exports to Australia hardly weigh for the US. The AUSFTA is estimated to generate potential economic advantage of $1.3 per head in the terms of equivalent variation in Case 1 for the US, well below Australia’s $2.2.

The results of this analysis cannot instantly confirm that the AUSFTA is unreasonable for Australia, but it is imagined that Australia had a chance to win higher profit by further negotiation and that Australia’s concession was excessive.

3) Impact on Trade (i) By Country or Region

Seeing the changes in total export by country or region in Table 3, the US’s increase is greatest in monetary terms at $1,316.1 million in Case 2 but the percentage change is only 0.15%. On the other hand, Australia’ increase amounts to $882.5 million, slightly lower than the US, but the percentage change is 1.25%, well above the US, and the greatest proportional change. Total global exports increase slightly by $1,053.8 million (+0.02%) but the total export changes in a negative direction everywhere except the US and Australia. New Zealand’s decline